Question

Lakeside Winery is considering expanding its winemaking operations. The expansion will require new equipment costing $665,000 that would be depreciated on a straight-line basis to zero over the 6-year life of the project. The equipment will have a market value of $176,000 at the end of the project. The project requires $46,000 initially for net working capital, which will be recovered at the end of the project. The operating cash flow will be $151,600 a year. What is the net present value of this project if the relevant discount rate is 12 percent and the tax rate is 40 percent?

Answer 1

Initial investment = cost of new equipment + working capital required = $665,000 + $46,000 = $711,000

Depreciation per year = $665,000 / 6 = $110,833.3333333

Depreciation tax shield per year = $110,833.3333333 x 40% = $44,333.333333

Present value of cash inflows

Particulars	Year 1 - 5	Year 6
Operating cash flow per year net of tax [ $151,600 x (1 - 0.40) ]	$90,960	$90,960
Add: Depreciation tax shield per year	$44,333.333333	$44,333.333333
Add: Salvage value net of tax [ $176,000 x (1 - 0.40) ]		$105,600
Add: Working capital recovered		$46,000
Total Cash Inflows	$135,293.333333	$286,893.333333
PVIF@12% [ see note ]	3.60477620241	0.50663112117
Present value of cash inflows	$487,702.19	$145,349.09

NPV = Total present value of cash inflows - initial investment = $633,051.28 - $711,000 = (-)$77,948.72

Note : For years 1 - 5 , we use present value interest factor annuity (PVIFA) which is computed as -

For year 6, we use present value interest factor (PVIF) which is computed as -